© rainer maurer, pforzheim - 1 - prof. dr. rainer maurer macroeconomics 4. the keynesian model and...

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- 1 -Prof. Dr. Rainer Maurer

MacroeconomicsMacroeconomics

4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications

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MacroeconomicsMacroeconomics4. The Keynesian Model and its Policy Implications

4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market

4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume

4.2.2. Reduction of the Propensity to Invest 4.2.3. Consequences for the Labor Market

4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy 4.3.2. Monetary Policy

4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions

4.5.1. Practical Problems of Anti-cyclical Policy 4.5.2. Case Study: Fiscal Policy in Germany

4.5.3. Limits of Government Debt 4.5.4. Case Study: Economic Policy in the Great

Recession 4.6. Questions for Review

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- 3 -- 3 -Prof. Dr. Rainer Maurer


Literature:

◆ Chapter 9, 10, 11, 13, 14 Mankiw, Gregory; Macroeconomics, Worth

Publishers.

◆ Kapitel 10, Baßeler, Ulrich et al.; Grundlagen u. Probleme der Volkswirtschaft, Schäfer-Pöschel.

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4.1. The Keynesian Theory

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications4.1. The Keynesian Theory4.1. The Keynesian Theory

➤ The Crisis of Neoclassical Theory

■ Until the world economic crisis of 1929, the neoclassical model was the consensus model of market oriented economists.

■ This appraisal of the neoclassical theory was altered by the world economic crisis.

■ Such a sharp and lasting break of economic development was inconsistent with the neoclassical hypothesis of the immanent stability of market economies.

■ Rising unemployment, bankrupt companies and decreasing incomes caused social problems that called for new solutions.

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications4.1. The Keynesian 4.1. The Keynesian TheoryTheory

Quelle: www.dowjones.com

The Development of the Dow Jones Index

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Real GDPConsum-

ptionInvest-ment

Governm. Consum.

% Change

Level % Change%

Change%

Change%

Change1929 3,21930 178,1% 8,9 -9,9% -6,6% -32,2% 10,5%1931 83,1% 16,3 -7,6% -3,3% -38,7% 4,5%1932 47,9% 24,1 -14,9% -9,0% -72,0% -4,7%1933 4,6% 25,2 -1,9% -1,7% 12,8% -3,7%1934 -12,7% 22,0 9,0% 4,7% 77,4% 14,2%1935 -7,7% 20,3 9,9% 6,3% 91,5% 1,5%1936 -16,3% 17,0 14,0% 10,3% 33,3% 17,8%1937 -15,9% 14,3 5,2% 3,4% 24,6% -3,1%1938 33,6% 19,1 -5,1% -2,0% -43,1% 10,1%1939 -9,9% 17,2 8,6% 5,7% 45,3% 3,8%1940 -15,1% 14,6 8,5% 5,1% 33,6% 3,4%

The World Economic Crisis in the USA

Quelle: US Bureau of Census

Unemployment RateYear

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Real GDPConsum-

ptionInvest-ment

Governm. Consum.

% Change

Level % Change%

Change%

Change%

Change1929 3,21930 178,1% 8,9 -9,9% -6,6% -32,2% 10,5%1931 83,1% 16,3 -7,6% -3,3% -38,7% 4,5%1932 47,9% 24,1 -14,9% -9,0% -72,0% -4,7%1933 4,6% 25,2 -1,9% -1,7% 12,8% -3,7%1934 -12,7% 22,0 9,0% 4,7% 77,4% 14,2%1935 -7,7% 20,3 9,9% 6,3% 91,5% 1,5%1936 -16,3% 17,0 14,0% 10,3% 33,3% 17,8%1937 -15,9% 14,3 5,2% 3,4% 24,6% -3,1%1938 33,6% 19,1 -5,1% -2,0% -43,1% 10,1%1939 -9,9% 17,2 8,6% 5,7% 45,3% 3,8%1940 -15,1% 14,6 8,5% 5,1% 33,6% 3,4%

The World Economic Crisis in the USA

Quelle: US Bureau of Census

Unemployment RateYear

The analysis of demand shocks in the neoclassical model has revealed that a reduction of consumption demand should lead to an increase in savings, which should reduce the interest rate such that demand for investment goods grows and replace the reduction in consumption (and vice versa).This mechanism did not work in the world economic crisis!

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➤ The Keynesian Theory■ Under these historical circumstances John Maynard Keynes

developed his new macroeconomic theory, which was intended to explain the consequences of the world economic crisis and to deliver economic policy recommendations appropriate to overcome such a crisis.

■ This theory was published in a book with the title “General Theory of Employment, Interest and Money” (1936).

■ In this book, Keynes contested two basic assumptions of the neoclassical theory by assuming that

1. …in the short run, goods prices are fix, so that they cannot de-crease in case of a reduction of goods demand. As a consequen-ce, he assumed that instead of goods prices the supply of goods adjusts to changes in demand = “Keynesian Price Rigidity”.

2. …household consumption is only a positive function of household income C(Y ↑)↑; the negative impact of the interest rate C(i↓)↑ can be neglected = “Keynesian Consumption Function”.

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➤ The Keynesian consumption function C(Y↑)↑ corresponds at first sight much better to empirical observations as the neoclassical consumption function C(i↑)↓.

➤ The empirical correlation between consumption and income is in deed much stronger than the empirical correlation between consumption and interest rates, as the following graphs demonstrate:

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Correlation between Consumption of Private Households and Disposable Income in Germany (Prices = 1995; 1980 - 2002)

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Disposable Income (=Y-T) in Bn. €

C(Y-T) = 0,89 *(Y-T)


= C(Y↑)↑

= Keynesian Consumption Function

Quelle: SVG (2003), eigene Berechnungen

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Correlation between Consumption of Private Households and Interest in Germany (Prices = 1995; 1980 - 2002)

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Real Interest Rate of Fixed Rate Securities in %

C(i) = 1022 - 2865 *(i)


= C(i↑)↓

= Neoclassical Consumption FunctionQuelle: SVG (2003), eigene Berechnungen

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➤ The second basic difference between Keynesian and neo-classical theory is the so called “Keynesian Price Rigidity”:

■ In neoclassical theory, an increase of production output causes an increase of marginal costs, so that firms increase their prices (and vice versa).

◆ Consequently, an increase of the demand for goods causes an increase of the prices of goods (and vice versa).

■ In Keynesian theory, firms do not immediately adjust their prices to production output:

◆ An increase (decrease) of the demand for goods causes a corresponding increase (decrease) of the supply of goods. The prices of goods stay however constant.

➤ Who is right – Keynes or the Neoclassics?

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- 18 -- 18 -Prof. Dr. Rainer MaurerQuelle: The Pricing Behavior of Firms in the Euro Area, EZB (2005)

Survey Period 2003-2004; Sample Size 11000 Firms;

BE = Belgium, DE= Germany; FR=France, IT=Italy LU= Luxembourg, NL=Netherlands, AT=Austria, PT=Portugal

➤ An large-scale empirical study of the European Central Bank has led to the following result:


Percentage Distribution of Firms According Their Frequency of Price Adjustments per Year

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➤ From these and similar studies follows:

■ Firms do not immediately adjust their prices to changes in costs.

■ Instead, they keep their prices constant over a longer period of time – just as assumed by Keynes.

➤ If firms try to maximize their profits, they should in principle change their prices when their costs change.

➤ Why then do firms not change their prices more often?

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➤ Why do prices not change more often?

■ In reality, changing prices causes costs:

◆ Internal organizational costs: Information of staff members, distribution chains, sales agents…

◆ External communication costs: Explication and justification of price changes to clients…

◆ Technical costs: printing costs of pricelists, mailing expenses…

■ If the costs per price change are higher than the return of a price change, a continuous adjustment of prices is not profit maximizing, as the following diagram shows:

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Costs per Price Change

Number of Price Changes per Year


0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0

The costs per price change will typically be constant or slightly increasing, if the number of price changes per year grows.

€

3 €

3 €

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0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0

The costs per price change will typically be constant or slightly increasing, if the number of price changes per year grows.

€

3 €

6 €

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0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0

The return per price change will typically decrease, if the number of price changes per year grows.

Return per Price Change

The return of 4 price changes per year will normally be lower, since it is not so likely that significant chan-ges of production costs and demand strength will occur every quarter…

€

The return of 1 price change every 2 years will normally be quite high, since it is very likely that significant changes of production costs and demand strength will occur within a time span of 2 years.

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0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0

More often price changes profitable

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Return of an additional price change higher than costs

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0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0

€

Return of an additional price change lower than costs

Less often price change profitable

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0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0

=> Profit maximizing number of price changes per year = 2

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0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0

=> Profit maximizing number of price changes per year = 2


€




Profit at 2 adjustments of prices per year

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0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0


€


Costs per Price Change1


Costs per Price Change2

=> The higher the costs per price adjustment, the lower the number of profit maximizing price adjustments per year!

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➤ As the diagrams show:

■ It is possible to explain, why firms on average do not change their prices more often than one time per year with the standard microeconomic profit-maximization behavior.

■ Depending on the relation between the costs and return of a price change it can be profit-maximizing to hold prices on average constant for a time span of a year or even longer.

■ Rigid price setting and profit maximization are compatible!

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➤ The Keynesian theory assumes therefore that in the “short-run” (= within a time span of one year) firms keep their prices constant:

P = constant within one year

➤ If the demand for goods changes in the short-run, firms do simply adjust their production instead of prices to the demand for goods.

➤ Consequently, in the short-run firms' production of goods Y is always equal to the sum of households consumption demand C plus firms’ demand for investment goods I plus government consumption demand G:

Y = C + I + G➤ Consequently, in the short-run demand for goods determines

supply of goods!

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➤ If we add now the Keynesian consumption function C(Y) we receive the following relationship:

Y = C(Y) + I + G

➤ Obviously, this is a circular relationship:

■ GDP Y depends on consumption C(Y) and consumption C(Y) depends on GDP Y and so on…

➤ As the following analysis will show, this circular relationship can boost the effects of economic policy (but complicates a bit the graphical analysis…).

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4.1. The Keynesian Theory4.1.1. The "Keynesian Cross"

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GIYCY )(

➤ Since prices are constant and supply always adjust to demand the following equation always holds in the Keynesian model:

➤ For simplicity we will first assume that I and G are constant.

➤ What exactly means C(Y)?➤ Example: Let the consumption rate be: c = 50% and Y = 100 :

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nConsumptio50100*5,0Y*c)Y(C

GoodsforDemandGDP


4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications4.1.1. The "Keynesian Cross"4.1.1. The "Keynesian Cross"

nConsumptioGov.InvestmentnConsumptio GDP

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➤ This means “Everything that increases demand increases GDP”:

➤ Restriction: This government consumption multiplier is only valid, if government consumption is financed with credits.

➤ As can be mathematically proven, financing government consumption with taxes yields a multiplier of exactly 1 under Keynesian assumptions.

c1

1:MultiplierInvestment

c1

1:MultipliernConsumptioGovernment

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-5

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Supply of Goods= Income = Y

Demand for Goods

Graphical exposition of these considerations:

C(Y)= 0,5 * Y

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-5

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Consumption (C) dependent on GDP (Y)

C(Y)= 0,5 * Y


Demand for Goods

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C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G


Demand for Goods

Government Consumption = G = 5

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C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+GInvestment = I = 5

YD = 0,5*Y+G+I


Demand for Goods

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C(Y) = 0,5 * Y

C(Y) + G = 0,5*Y+G

YD = 0,5*Y+G+I

At what level does income generate a demand for goods,

which is again equal to the level of income?

= Where does the equation 0,5*Y+G+I = Y hold?

At what level of income (Y) does the total demand for goods equal income?


Demand for Goods

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Every point on this 45°-line implies:

Demand for Goods = Supply of Goods


Demand for Goods

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C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G

YD = 0,5*Y+G+IThe 45°-line reveals the solution:


Demand for Goods

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C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G

YD = 0,5*Y+G+I

Consumption = 0,5 * (20) = 10

Gov. Consumption = 5

Investment = 5


Demand for Goods

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3. Das keynesianische Modell der Volkswirtschaft3. Das keynesianische Modell der Volkswirtschaft3.1. Die Struktur des keynesianischen Modells3.1. Die Struktur des keynesianischen Modells

Digression: What happens, if supply of goods is larger than the

equilibrium value = if there is excess supply ?

The following digression shows that in this case an adjustment process takes place.

Since supply of goods under Keynesian assumptions always adjusts to demand for goods, supply falls until it equals demand:

F49-F66

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➤ What happens now, if the equilibrium on the market for goods is disturbed by a sudden increase in investment demand?

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C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G

YD = 0,5*Y+G+I

How strong is GDP-growth, if investment grows by 5 ?


Demand for Goods

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-5

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C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G

YD = 0,5*Y+G+I

YD= 0,5*Y+G+I+ΔI

Increase in Invest-ment by 5


How strong is GDP-growth, if investment grows by 5 ?

Demand for Goods

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C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G

YD = 0,5*Y+G+I

YD= 0,5*Y+G+I+ΔI

Supply of Goods= Income = Y Increase in GDP by 10 = 5 * (1/(1-0,5))


Demand for Goods

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-5

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C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G

YD = 0,5*Y+G+I

YD= 0,5*Y+G+I+ΔI

Consumption = 0,5 * 30 = 15

Gov. Consumption = 5

Investment = 10


Increase in invest-ment by

5

Demand for Goods

Consumption = 0,5*20 = 10

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-5

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C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G

YD = 0,5*Y+G+I

YD= 0,5*Y+G+I+ΔI

As implied by the investment multiplier 1/(1-c), a consumption ratio of c = 50% together with an increase in investment by 5 causes GDP to grow by 10 = 5 * (1/(1-0,5)) = 5 * 2.



Demand for Goods

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➤ The following diagram graphically illustrates the multiplier effect:

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What causes the multiplier effect?

YD= 0,5*Y+G+I+ΔI

YD = 0,5*Y+G+I

C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G1st: Increase in Demand by 5



Demand for Goods

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-5

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YD= 0,5*Y+G+I+ΔI

YD = 0,5*Y+G+I

C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G

2nd: Increase in Income by 5 = ΔY



Demand for Goods


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-5

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YD= 0,5*Y+G+I+ΔI

YD = 0,5*Y+G+I

C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G

3rd: Increase in Consumption by c*ΔY = 0,5 * 5 = 2,5


Demand for Goods



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C(Y-T) + GC(Y)= 0,5*Y+G

YD= 0,5*Y+G+I+ΔI

YD = 0,5*Y+G+I

C(Y)= 0,5 * Y

4th: Increase in Income by ΔY = 2,5


Demand for Goods



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YD= 0,5*Y+G+I+ΔI

YD = 0,5*Y+G+I

C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G

5th: Increase in Consumption by c*ΔY = 0,5 * 2,5 = 1,25


Demand for Goods



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YD= 0,5*Y+G+I+ΔI

YD = 0,5*Y+G+I

C(Y)= 0,5 * Y

C(Y) + G = 0,5*Y+G

etc...


Demand for Goods


=> The primary increase in investment demand by 5 is multi-plied by the additional increase in consum-ption demand by factor 2 = 1/ (1-0,5).

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➤ Verbal Description of the Multiplier Process:

■ An increase in investment demand by 5 causes an increase in total supply (which does always adjust to total demand) by 5 .

■ This causes an increase in household income by 5 .■ This increase in income by 5 and a consumption ratio of 50 %

causes an increase in consumption by 0,5 * 5 = 2,5 .■ This increase in consumption demand by 2,5 causes an

increase in total supply by 2,5 .■ This causes an increase in household income by 2,5 .■ This increase in income by 2,5 and a consumption ratio of 50 %

causes an increase in consumption by 0,5 * 2,5 = 1,25 .■ This increase in consumption demand by 1,25 causes in

increase in total supply by 1,25 .■ This causes an increase in household income by 1,25 .■ This increase in income by 1,25 and a consumption ratio of 50 %

causes an increase in consumption by 0,5 * 1,25 = 0,625 , and so on ...

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4.1. The Keynesian Theory4.1.1. The "Keynesian Cross"4.1.2. The Keynesian Model with Capital Market

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications4.1.2. The Keynesian Model with Capital Market4.1.2. The Keynesian Model with Capital Market

➤ The Keynesian Model with Capital Market■ The "Keynesian Cross" reveals the basic features of the

Keynesian Theory.■ It suffers, however, from the shortcoming of constant investment.■ Keynes assumed that firms' investment depends on two factors:

1. the capital market interest rate (i), which represents the costs of investment, and

2. the expected return on investment E(r), where the function “E(r)” symbolizes the expectation value of the return on investment “r”.

■ Like the Neoclassics, Keynes assumed that a higher (lower) interest rate reduces (increases) firm investment, since it increases (lowers) investment costs.

■ Following Keynes, an increase (decrease) of the expected return on investment, increases (decreases) firm investment, since more investment projects become profitable at a higher return.

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications4.1.2. The Keynesian Model with Capital Market 4.1.2. The Keynesian Model with Capital Market

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Investment

Interest Rate

Investment demand I(i) negatively depends on the interest rate i.

I(i, E(r1))

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Interest Rate

Investment demand of firms I(i) positively depends on expected return E(r): If the expected return increases, investment

demand increases too.

I(i, E(r2))

E(r1) < E(r2)

I(i, E(r1))

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Interest Rate

Investment demand of firms I(i) positively depends on expected return E(r): If the expected return decreases, investment

demand decreases too.

I(i, E(r2))

E(r1) > E(r2)

I(i, E(r1))

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Demand

Investment

Interest Rate

C(Y)= 0,5* Y

Since household consumption depends on household income C(Y), household savings, which equal household income minus household consumption, depends on income too: Y – C(Y) = S(Y). If for example

household income is Y = 30 and the consumption ratio is c = 50% household savings equal S(Y) = Y – C(Y) = 30 – 0,5*30 = 15

Income = Y

I(i, E(r1))

Consequently, savings like consumption do not depend on the interest rate!

C(Y)+I(i, E(r1))

S= 15 = 0,5*30

S(Y) = 0,5*Y

Y = 30

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Demand

Investment

Interest Rate

i1

C(Y)= 0,5* Y

As the capital market diagram now shows, at the resulting interest rate i1 the demand for investment goods equals I1 = 15 too, so that the resulting equilibrium income is indeed equal to Y=30. This somewhat astonishing result is not due to

chance but a consequence of a mathematical law called “Walras’ Law”.

Income = Y

I(i, E(r1))

C(Y)+I(i, E(r1))S(Y) = 0,5*Y

I1 = 15

I = 15

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Digression: Walras’ Law

“Walras’ Law” was discovered by the French economist Léon Walras and 1874 published in his book “Éléments d’èconomie politique pure”. Is says:

“If the number of all markets in an economy is equal to N and N-1 markets are in equilibrium (i.e. demand equals supply on N-1 markets) and all households keep their budgets (i.e. spend not more and not less money for consumption and savings than equals their income), then the Nth market will automatically be in equilibrium too (i.e. demand equals supply on the Nth market too).”

In the above version of a Keynesian model only two markets exist: The goods market and the capital market. Hence N=2. Consequently, if the goods market is in equilibrium such that

Y = C(Y) + I(i, E(r))and the household keeps its budget constraint such that

Y = C(Y) + S(Y)then, the capital market must necessarily be in equilibrium too, i.e. savings supply S(Y) must be equal to investment demand I(i, E(r)) such that

S(Y)= I(i, E(r))It is easy to see that this is actually true, if one subtracts the budget constraint from the goods market equilibrium equation:

Y – [Y] = C(Y) + I(i, E(r)) – [C(Y) + S(Y)]<=> 0 = I(i, E(r)) – S(Y)<=> S(Y) = I(i, E(r))

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4. The Keynesian Model and its Policy Implications


4.1.1. The "Keynesian Cross"

4.1.2. The Keynesian Model with Capital Market


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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications4.2.1. Reduction of the Propensity to Consume 4.2.1. Reduction of the Propensity to Consume

➤ Since under Keynesian assumptions, the supply of goods does always adjust to the demand for goods, a reduction of demand causes immediately a reduction of GDP:

■ If households expect a deterioration of the economic development, so that they fear unemployment and increase their savings to have a financial “safety cushion” in the case they become unemployed, they reduce their consumption demand.

■ Consequently, what they have expected, a deterioration of the economic development, does actually occur.

■ Such a phenomenon is called “self-fulfilling expectations”: What is expected does actually happen, because it is expected.

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications4.2.1. Reduction of the Propensity to Consume 4.2.1. Reduction of the Propensity to Consume

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Demand

Investment

Interest Rate

i1

C(Y)= 0,5* Y

C(Y) + 15

I1=15

Income = Y

I(i, E(r1))

Y1S1= 15

What happens, if households expect a deterioration of economic development and do therefore increase their savings ratio from (1-c) =

50% to (1-c) = 75%?

S(Y) = 0,5*Y

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications 4.2.1. Reduction of the Propensity to Consume4.2.1. Reduction of the Propensity to Consume

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0 5 10 15 20 25 30 35 40 45 50

Demand

Investment

Interest Rate

i1

C(Y)= 0,5* Y

C(Y) + 15

I1=15

Income = Y

I(i, E(r1))

Y1S1= 15


50% to (1-c) = 75%?

S(Y) = 0,5*Y

The consumption ratio decreases from c = 50% to c = 25%

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0 5 10 15 20 25 30 35 40 45 50

Demand

Investment

Interest Rate

i1

C(Y)= 0,5* Y

0,5*Y + 15

I1=15

Income = Y

I(i, E(r1))

Y1S1= 15

S(Y) = 0,5*Y

C(Y)= 0,25* Y

0,25*Y + 15


50% to (1-c) = 75%?


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Demand

Investment

Interest Rate

i1

I1=15

Income = Y

I(i, E(r1))

Y2S2= 15

S(Y) = 0,75*Y


C(Y)= 0,25* Y

0,25*Y + 15

=> GDP decreases from Y1=15 * (1/(1-0,5) = 30 to Y2= 15 * (1/(1-0,25) = 20

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Demand

Investment

Interest Rate

i1

I1=15

Income = Y

I(i, E(r1))

Y2S2= 15

S(Y) = 0,75*Y

Savings and investment remain unchanged, since the increase in the savings ratio 0,75 = (1-0,25) does exactly compensate for the decrease in GDP to a level

of 20:1)

S(Y1) = (1-0,5) * 30 = 0,5 * 30 = 15 = S(Y2)= (1 - 0,25) * 20 = 0,75 * 20

C(Y)= 0,25* Y

0,25*Y + 15

1) All variables change simultaneously. Therefore savings must not be calculated based on starting income (=30). The resulting income of a period is not given before the end of a period, which equals 20 in the given example.

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4.2. Demand-side Shocks

4.2.1. Reduction of the Propensity to Consume

4.2.2. Reduction of the Propensity to Invest

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications4.2.2. Reduction of the Propensity to Invest 4.2.2. Reduction of the Propensity to Invest

➤ Since under Keynesian assumptions, supply of goods does always adjust to demand for goods, a reduction of demand causes immediately a reduction of GDP:

■ If firms expect a deterioration of economic development, so that they fear a decrease in investment return, they reduce their demand for investment goods so that their expectations actually realize.

■ Consequently, what they have expected, a deterioration of the economic development, does actually occur.

■ Consequently, firms too can cause “self-fulfilling expectations”: What is expected does actually happen, because it is expected.

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Demand

Investment

Interest Rate

i1

C(Y) + 15

I1=15

Income = Y

I(i, E(r1))

Y1S1= 15

What happens, if firms expect a lower investment return r2 < r1 , because of a deterioration of the economic development and lower their

investment from 15 to 5 ?

S(Y) = 0,5*Y

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Demand

Investment

Interest Rate

i1

C(Y) + 15

Income = Y

I(i, E(r1))

S1= 15

C(Y) + 5

Y1

S(Y) = 0,5*Y

I(i, E(r2))


1) All variables change simultaneously. Therefore, both demand curves must be shifted simultaneously. (If only the credit demand curve were shifted, the decreasing interest rate would increase investment demand to its starting level.)

The demand for investment goods and the demand for credits to finance these investment goods decrease.1)

I2=5

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0 5 10 15 20 25 30 35 40 45 50

Demand

Investment

Interest Rate

i1

C(Y) + 15

Income = Y

I(i, E(r1))

S2= 5

C(Y) + 5

Y2

S(Y) = 0,5*Y

I(i, E(r2))


If investment equals 5 and the consumption ratio is 50%, the resulting GDP equals Y = 5 * ( 1/(1-0,5) ) = 5 * 2 = 10

For an consumption ratio for c = 50% the savings ratio will equal (1-c) = 50%, so that at a GDP of 10, savings equal S(Y) = 0.5 * 10 = 5.

I2=5

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Demand

Investment

Interest Rate

i1

Income = Y

C(Y) + 5

Y2

I(i, E(r2))

S2= 5

S(Y) = 0,5*Y

If investment equals 5 and the consumption ratio is 50%, the resulting GDP equals Y = 5 * ( 1/(1-0,5) ) = 5 * 2 = 10

For a consumption ratio of c = 50% the savings ratio will equal (1-c) = 50%, so that at a GDP of 10 savings equal S(Y) = 0.5 * 10 = 5.


I2=5

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4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Invest


4.2.3. Consequences for the Labor Market

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications 4.2.3. Consequences for the Labor Market4.2.3. Consequences for the Labor Market

➤ As the preceding chapter has revealed, a deterioration of consumer and/or investor expectations concerning the economic development can actually cause a recession – a reduction of GDP.

➤ A reduction of GDP means however that firms also reduce their demand for production factors - notably their demand for labor:

■ If wages are not flexible, but fixed by collective labor agreements, labor supply stays unchanged.

■ If labor demand slumps while labor supply stays constant, unemployment will emerge.

■ This kind of unemployment is ultimately caused by a reduction in the demand for goods.

■ It is called “Keynesian unemployment”

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- 117 -

P1

w1_

The Effect of the Demand for Goods on the Labor Market

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L

Y

L

Y(LD1,K1)

LD1(w1/P1,K1)

Y(L,K1)

LS(w/p)

Under the assumptions of the neoclassical model (s. chapter 2.1.) the supply of goods depends on the equilibrium labor input LD(w1/P1,K1) and the given capital stock K1.

The resulting level of GDP is called "Normal Capacity GDP” or (since there is no unemployment) "Full Employment GDP“.

LD (w/p,K1)

"Normal Capacity GDP" or "Full Employment GDP"

Labor Demand of the Neoclassical Model

LD1(w1/P1,K1)

Equilibrium Labor Input

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L

Y

L

Y(LD1,K1)

LD1(w1/P1,K1)

Y(L,K1)

LS(w/p)

Under the assumption of the Keynesian model, firms adjust in the short run their production of goods to the demand for goods. Therefore they will also adjust their labor demand to the demand for goods in the short run!

Consequently, in the short run, the labor demand of firms is, under Keynesian assumptions, not determined by the real wage w/P and the given capital stock K1, i.e. by LD(w/P,K1), but by the demand for goods YD.

The "short-run" demand for labor therefore equals LD(YD)

LD (w/p,K1)


Labor Demand of the Neoclassical Model

LD1(w1/P1,K1)

Equilibrium Labor Input

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L

Y

L

LD1(w1/P1,K1)

Y(L,K1)

LS(w/p)

If the demand for goods equals the full employment GDP, i.e. YD= Y(LD1,K1), Keynesian labor demand will equal the equilibrium labor input of the neoclassical model: LD(YD) = LD(w1/P1,K1).

LD (w/p,K1)


Keynesian Labor Demand

LD(YD,1)

YD,1

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0

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L

Y

L

L1

L1

Y(L,K1)

LD(YD,2)

If the demand for goods falls (for one of the reasons discussed in section 3.2.) below the full employment GDP, i.e. YD< Y(LD1,K1), Keynesian labor demand will be lower than the equilibrium labor input of the neoclassical model: LD(YD) < LD(w1/P1,K1).

If the real wage is downward fixed by a collective bargaining contract to the long-run market equilibrium level of w1/P1, the resulting unemployment is called “Keynesian unemployment”

YD,2

Decrease of Keynesian

Labor Demand in a Recession LS(w/p)

Decrease of GDP below its Full Employment Level in a

Recession

LD(YD,1)

YD,1

Keynesian Unemployment

LME ECB

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0

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L

Y

L

L1

L1

Y(L,K1)

LD(YD,2)

We know from section 3.2. that also the opposite can happen: The demand for goods can grow above full employment GDP, i.e. YD > Y(LD1,K1). Then Keynesian labor demand will be higher than the equilibrium labor input of the neoclassical model: LD(YD) > LD(w1/P1,K1).

Since collective bargaining contracts typically allow an increase of wages, wages will grow (also due to overtime premiums). The result is called “Keynesian overemployment”

YD,2

Increase in Short-run Labor Demand in a

Boom

LS(w/p)

Keynesian Overemployment

Increase in GDP above its Full Employment Level in a

Boom

P1

w2_

LD(YD,1)

YD,1

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- 122 -

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

1970197119721973197419751976197719781979198019811982198319841985198619871988198919901991199219931994199519961997199819992000200120022003200420052006200720082009

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2200

2400

BIP-Wachstum minus Wachstum des 7-jahres Durchschnitts (linke Skala)

Gleitender 7-jahres Durchschnitt des BIPs (rechte Skala)

BIP (rechte Skala)

Bn. €

Percentage Change Year over Year

Classification of Business Cycles Based on the Difference between Actual GDP Growth and GDP Growth Trend (Prices = 2000)

GDP Growth Minus 7 Year Growth Trend (left scale)

7 Year Moving Average GDP (right scale)

GDP (right scale)- 122 -Prof. Dr. Rainer MaurerSource: EU-Ameco Database

Classification of Business Cycles: Actual GDP Growth > Growth Trend =UpswingActual GDP Growth < Growth Trend =Downswing

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- 123 -

-4%

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1970197119721973197419751976197719781979198019811982198319841985198619871988198919901991199219931994199519961997199819992000200120022003200420052006200720082009

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2400

BIP-Wachstum minus Wachstum des 7-jahres Durchschnitts (linke Skala)Gleitender 7-jahres Durchschnitt des BIPs (rechte Skala)BIP (rechte Skala)

Bn. €Percentage Change Year over Year

GDP Growth Minus 7 Year Growth Trend (left scale)7 Year Moving Average GDP (right scale)GDP (right scale)

Classification of Business Cycles Based on the Difference between Actual GDP Growth and GDP Growth Trend (Prices = 2000)

UPSWING

DOWNSWING

UPSWING

UPSWING

UPSWING

DOWNSWING

DOWNSWING

DOWNSWING

DOWNSWING

UPSWING

UPSWING

DOW

NSWING

UPSWING


Classification of Business Cycles: Actual GDP Growth > Growth Trend =UpswingActual GDP Growth < Growth Trend =Downswing

Source: EU-Ameco Database

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0%

2%

4%

6%

8%

10%

12%

14%

196019621964196619681970197219741976197819801982198419861988199019921994199619982000200220042006200820102012

West Germany Germany

Long-run Development of the German Unemployment Rate


Source: EU-AMECO Data Base

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4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Invest



4.3. Fiscal and Monetary Policy in the Keynesian Model4.3.1. Fiscal Policy

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➤ As we have already seen, there are two types of fiscal policy depending on their way of financing:■Debt Financed Fiscal Policy■Tax Financed Fiscal Policy

➤ If the government finances its consumption (G) by taxes (T) and by debt (DG) the following budget constraint results:■G = T + DG

➤ To simplify the following analysis we will analyze only debt financed fiscal policy:■G = DG | Debt Financed Fiscal Policy

➤ Under Keynesian assumptions, tax financed fiscal policy has the same results, yet the strength of the effect is somewhat weaker, since it lacks a multiplier effect (Haavelmo-Theorem).

4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications 4.3.1. Fiscal Policy4.3.1. Fiscal Policy

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-5

0

5

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0 5 10 15 20 25 30 35 40 45 50


Yi

i#

C(Y)

Y

-0,5

0

0,5

1

1,5

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2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

I°I,S

Y°D

I(i, E(r°))

C(Y) + I°S(Y) = 0,5*Y

I°

Starting point is a situation, where a demand-side recession has caused GDP to fall to a level of Y°D below its full employment level Y#

D, so that Keynesian unemployment has emerged.

What happens then, if the government rises its consumption from G=0 to G=5and finances this expenditure with new debt of DG=G=5 via the credit market?

Y#D

Full Employ-ment GDP


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-5

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Yi

i#

C(Y)

Y

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2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

I°I,S

I° Y°D

I(i, E(r°))

C(Y) + I°S(Y) = 0,5*Y C(Y) + I° + G

The rise of government consumption from G=0 to G=5 raises total demand for goods by 5.

Y#D


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-5

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Yi

i#

C(Y)

Y

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2,5

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3,5

0 5 10 15 20 25 30 35 40 45 50

I°I,S

I° Y°D

I(i, E(r°))

C(Y) + I°S(Y) = 0,5*Y C(Y) + I° + G

I(i, E(r°)) + DG

Y#D

The multiplier effect then causes total demand to grow by additional 5 units, so that total GDP grows by 10.

To finance this additional government consumption, the credit demand grows by the government demand for credits equal to G=DG=5.


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-5

0

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Yi

i#

C(Y)

Y

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2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

I°I,S

I° Y°D

I(i, E(r°))

C(Y) + I°S(Y) = 0,5*Y C(Y) + I° + G

I(i, E(r°)) + DG

Since the increase in income by 10, increases, for a given savings ratio of 50%, the credit supply of households by 5, credit supply of households grows by the same amount as government consumption.

Y#D


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-5

0

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Yi

i#

C(Y)

Y

-0,5

0

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1,5

2

2,5

3

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0 5 10 15 20 25 30 35 40 45 50

S(Y) = 0,5*Y

I°I,S

I(i, E(r°)) + DG

I° Y°D

I(i, E(r°))

C(Y) + I°C(Y) + I° + G

The rise of GDP to its full employment level Y#D, increases the demand for

labor to its full employment level LD(Y#D)=LD(w1/P1,K1), so that the Keynesian

unemployment disappears.

Y#D


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P1

w1_

4.3.1. Fiscal Policy4.3.1. Fiscal Policy

0

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0

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8

1 0

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1 8

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2 8

3 0

0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0 2 2 2 4 2 6 2 8 3 0 3 2 3 4 3 6 3 8 4 0

L

Y

L

Y#D

L1

L1

Y(L,K1)

LD(Y°D)

The increase of GDP from Y°D to Y#

D caused by the increase of government consumption causes an increase of the short-run demand for labor from LD(Y°D) to LD(Y#

D). Consequently, the Keynesian Unemployment caused by the recession completely disappears. If the increase of government consumption were lower that G=5, Keynesian unemployment would not completely disappear. If the increase of government consumption were stronger than G=5, GDP would grow stronger than Y#

D. This would cause an "overheating" of the economy.

Y°D

LD(Y#D)

LS(w/p)Keynesian Unemployment

LS(w/p)

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P1

w1_

4.3.1. Fiscal Policy4.3.1. Fiscal Policy

0

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6

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1 6

1 8

2 0

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2 6

2 8

3 0

0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0 2 2 2 4 2 6 2 8 3 0 3 2 3 4 3 6 3 8 4 0

0

2

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8

1 0

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1 6

1 8

2 0

2 2

2 4

2 6

2 8

3 0

0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0 2 2 2 4 2 6 2 8 3 0 3 2 3 4 3 6 3 8 4 0

L

Y

L

Y#D

L1

L1

Y(L,K1)

LD(Y°D)

The increase of GDP from Y°D to Y#

D caused by the increase of government consumption causes an increase of the short-run demand for labor from LD(Y°D) to LD(Y#

D). Consequently, the Keynesian Unemployment caused by the recession completely disappears. If the increase of government consumption were lower that G=5, Keynesian unemployment would not completely disappear. If the increase of government consumption were stronger than G=5, GDP would grow stronger than Y#

D. This would cause an "overheating" of the economy.

Y°D

LD(Y#D)

LS(w/p)Disappearance of Keynesian Unemployment

LS(w/p)

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➤ Why is fiscal policy able to cause an economic recovery under Keynesian assumptions, but not under the assumptions of the neoclassical model?

■Under the assumption of the neoclassical model, the supply of goods is fix. An increase in the demand for goods cannot cause an increase in the supply of goods:

◆The increase in government debt, causes an increase in the demand for credits.

◆Since the supply of credits does, however, not grow, the resulting increase in the interest rate causes a reduction of investment (I(i↑)↓) and a reduction of household consumption (C(i↑)↓).

◆ This is the reason for the complete „Crowding-Out“ under neoclassical assumptions.

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➤ Why is fiscal policy able to cause an economic recovery under Keynesian assumptions, but not under the assump-tions of the neoclassical model?

■Under the assumptions of the Keynesian model, the supply of goods adjusts to the demand for goods, so that GDP and hence household income grows.

◆The increase in government debt, causes an increase in the demand for credits.

◆The increase in GDP causes at the same time an increase in household savings, so that credit supply grows.

◆The increase in household credit supply is sufficient to compensate the effect of additional government credit demand on the interest rate.

◆Therefore, an increase in the interest rate does not take place!◆Therefore, investment demand for firms does not decrease.◆As a consequence, a debt-financed expansion of government

consumption does not result in a „Crowding-Out“ of private demand!Tax financed fiscal policy?

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4.3. Fiscal and Monetary Policy in the Keynesian Model4.3.1. Fiscal Policy

4.3.2. Monetary Policy

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy4.3.2. Monetary Policy

➤ In the above analysis of fiscal policy the existence of money supply and demand was neglected by assuming implicitly a pure barter economy.■Under the existence of money, the effect of fiscal policy would

be somewhat dampened, because an increase in GDP increases the demand for money and consequently the interest rate, so that investment demand shrinks somewhat and the net increase in GDP is correspondingly smaller.

■Nevertheless, the net effect of fiscal policy on GDP is significantly positive, even in a Keynesian model with money.

■In this sense, the neglect of money is harmless.

➤ Of course, in the following analysis of monetary policy, we cannot neglect the existence of money .

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➤ The Determinants of Money Supply:

■Just like in the neoclassical model, the central bank determines money supply: MS

■As the discussion of monetary policy in Chapter 6 will show, most central banks offer in various ways their money as a credit on the capital market.

■Therefore, we can simply add money supply of the central bank to credit supply of households.

■Consequently, total real credit supply equals the sum of real savings of households plus the real value of money supply by the central banks ( =nominal money supply (MS) divided by the price level P:

Total Real Credit Supply = S(Y) + MS / P

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➤ The Credit Market without Money Supply and Demand:

i#

-0,5

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I(i, E(r°))

S(Y)

I°

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➤ The Credit Market with Money Supply:

i#

-0,5

0

0,5

1

1,5

2

2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

I(i, E(r°))

S(Y) S(Y) + MS / P

MS/P

I° + RD°I°

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➤ Determinants of Money Demand:

■Just like in the neoclassical model, firms demand money to pay their production factors labor and capital.

■Consequently, the real demand for money depends on the sum of real wage and real interest payments, which equal real GDP: Y.

■Additionally, the original Keynesian model accounts for the fact, that households and firms care for the opportunity costs of holding money (= interest costs = interest rate = i) and do therefore demand less money if the interest rate is high and vice versa. For simplicity we will neglect the dependency of money demand on the interest rate in the following exposition, since it has no significant effects on the results.

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➤ Determinants of Money Demand:

■ Consequently, real money demand depends like in the neoclassical model positively on GDP (Y) :

Real Money Demand = RD(Y)

■ Total real credit demand equals then credit demand for the purchase of investment goods I(i, E(r)) plus money demand:

Total Real Credit Demand = I(i, E(r)) + RD(Y)

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➤ The Credit Market with Money Supply:

i#

-0,5

0

0,5

1

1,5

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2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

I(i, E(r°))

S(Y) S(Y) + MS / P

MS/P

I° + RD°I°

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➤ The Credit Market with Money Supply and Money Demand:

i#

-0,5

0

0,5

1

1,5

2

2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

I(i, E(r°))

S(Y)

I(i, E(r°)) + RD(Y)

S(Y) + MS / P

MS/P

RD(Y)

I° + RD°I°

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- 149 -

➤ The Credit Market with Money Supply and Money Demand:


-0,5

0

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1

1,5

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2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50


i#

I°

I(i, E(r°))

S(Y)

I(i, E(r°))+ RD(Y)

S(Y) + MS / P

MS/P

If money supply (MS/P) equals money demand (RD(Y)), the

interest rate equals the natural interest rate, i.e. the

interest rate that would result without money.

I° + RD°

RD(Y)

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➤ The capital market with money supply and demand can now be inserted into the Keynesian model:

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- 151 -

-5

0

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0 5 10 15 20 25 30 35 40 45 50


-0,5

0

0,5

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1,5

2

2,5

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3,5

0 5 10 15 20 25 30 35 40 45 50

Yi

i°C(Y)

YI°

I,S

C(Y)+I°

I°+RD°

I(i)

I°

Starting point is a situation, where a demand-side recession has caused GDP to fall to a level of Y°D below its full employment level Y#

D, so that Keynesian unemployment has emerged.

Y°D Y#D


S(Y°) S(Y°)+M/P


Ex. 25, sl. 195

I(i)+RD(Y°)

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- 152 -

-5

0

5

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0 5 10 15 20 25 30 35 40 45 50


-0,5

0

0,5

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2,5

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3,5

0 5 10 15 20 25 30 35 40 45 50

Yi

C(Y)

YI°

I,S

C(Y)+I°S(Y°)+M/P+5

I°+RD°

i°

I(i)+RD(Y°)

I(i)

I°

What happens now, if the central bank rises money supply and hence total credit supply by ΔM /P= 5 ?

Y°D Y#D


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-5

0

5

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0 5 10 15 20 25 30 35 40 45 50


-0,5

0

0,5

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1,5

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2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

Yi

i# C(Y)

YI°

I,S

C(Y)+I°S(Y°)+M/P+5

I(i)

I# I#+RD°

i°

I°

The raise of money supply causes a reduction of the interest rate from i° to i#. This rises investment from I° to I#.

Y°D Y#D


I(i)+RD(Y°)

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-5

0

5

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0 5 10 15 20 25 30 35 40 45 50


-0,5

0

0,5

1

1,5

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2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

Yi

i# C(Y)

YI,S

I°

C(Y)+I°S(Y°)+M/P+5

I(i)

I# I#+RD°

i°

C(Y)+I#

I#

I°

The rise of investment by 5 increases the demand for goods by 5. The multiplier process causes a final increase in GDP by 10 units.

Y°D Y#D


I(i)+RD(Y°)

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-5

0

5

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0 5 10 15 20 25 30 35 40 45 50


-0,5

0

0,5

1

1,5

2

2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

Yi

i# C(Y)

YI,S

I°

C(Y)+I°S(Y°)+M/P+5

I(i)

I# I#+RD°

i°

C(Y)+I#

I#

The growth of GDP causes a higher demand for labor, so that labor demand grows and Keynesian unemployment disappears.

Y°D Y#D


I(i)+RD(Y°)

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-5

0

5

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0 5 10 15 20 25 30 35 40 45 50


-0,5

0

0,5

1

1,5

2

2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

Yi

i# C(Y)

YI,S

S(Y#)+M/P+5

I#

I(i)+RD(Y°)

I#+RD°

C(Y)+I#

I#I(i)

C(Y)+I°

S(Y°)+M/P+5

Since GDP grows by 10, household savings grow by 10 times the savings ratio: 10*(1-c) = 10*0,5 = 5. This causes credit supply to shift to the right by 5

units.

Y°D Y#D


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-5

0

5

10

15

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35

0 5 10 15 20 25 30 35 40 45 50


-0,5

0

0,5

1

1,5

2

2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

Yi

i# C(Y)

YI,S

S(Y#)+M/P

I#

I(i)+RD(Y#)

I#+RD°

C(Y)+I#

I#I(i)

C(Y)+I°

This would cause a further decrease in the interest rate. However the increase in GDP causes also an increase in money demand, so that the

RD(Y)-curve shifts to the right too.

Y°D Y#D


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Prof. Dr. Rainer Maurer

-0,5

0

0,5

1

1,5

2

2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

Yi

i# C(Y)

YI,S

S(Y#) S(Y#)+M/P

I(i)

I#

I(i)+RD(Y#)

I#+RD#

C(Y)+I#

I#

To simplify the analysis, we make the assumption that money demand RD(Y) shifts to the right by the same amount as the savings supply, so that the interest

rate stays constant at the level caused by monetary policy i#. In this case the adjustment process comes to an end. If the shift of money demand were smaller,

a further decrease of the interest rate would cause a further growth of GDP.

Y°D Y#D


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MacroeconomicsMacroeconomicshttp://www.businessweek.com/articles/2014-10-30/why-john-maynard-

keyness-theories-can-fix-the-world-economy

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4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy

4.3.2. Monetary Policy

4.4. The Long-run Implications of the Keynesian Model

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➤ As section 3.1 has shown that in reality it takes one year until firms start to adjust their prices.

■When firms adjust their prices, they will do so according to the current degree of their capacity utilization:

◆When a rise in the demand for goods has caused a boom so that production lies above full employment GDP, firms will notice that an increase in prices will help to increase their profits.

◆When a decline in the demand for goods has caused a recession so that production lies below full employment GDP, firms will notice that a decrease in prices will help to increase their profits.

➤ In the following, we will therefore analyze what happens, if the economy is in a recession (production below the full employment level) and firms start to reduce their prices.

4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications4.4. The Long-run Implications of the Keynesian Model4.4. The Long-run Implications of the Keynesian Model

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-5

0

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0 5 10 15 20 25 30 35 40 45 50


-0,5

0

0,5

1

1,5

2

2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

P

Y

C(Y)

YI°

Y°

C(Y)+I°i°

I°

I,SI(i)

I(i)+RD(Y°)

I°+RD°

S(Y°)+M/P#

S(Y°)+M/P°

When the price level of goods prices decreases from P° to P#, the real value of the money offered by the central bank increases: (MD/P↓)↑ This causes an increase in credit supply from S(Y°)+MD/P° to S(Y°)+MD/P#


Y#


P°> P#

The resulting lower interest rate i# triggers the same adjustment process as discussed in section “4.3.2. Monetary Policy”!

i#

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-5

0

5

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15

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0 5 10 15 20 25 30 35 40 45 50


-0,5

0

0,5

1

1,5

2

2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

Y

C(Y)

YI°

Y°

C(Y)+I°i°

I°

I,SI(i)

I(i)+RD(Y°)

I#+RD°

i#

I#

S(Y°)+M/P#

This increase in credit supply causes the interest rate to decrease from i° to i#. The lower interest rate causes a rise of investment from I° to I#.


Y#

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-5

0

5

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15

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0 5 10 15 20 25 30 35 40 45 50


-0,5

0

0,5

1

1,5

2

2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

Y

C(Y)

YI#

Y°

C(Y)+I°i°

I°

I,SI(i)

I(i)+RD(Y°)

I#+RD°

i#

I#

C(Y)+I#

Y#

S(Y°)+M/P#

This increase in investment increases the demand for goods from Y°D to Y#D.

Since the supply of goods adjusts to the demand for goods, the demand for labor grows to the full-employment level.


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- 173 -

-5

0

5

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35

0 5 10 15 20 25 30 35 40 45 50


Y

C(Y)

YI#

I,S

I(i)+RD(Y#)i#

I#

C(Y)+I#

S(Y#)+MD/P#

S(Y°)+M/P#

I#+RD#

The resulting rise of GDP from Y°D to Y#D increases household savings from

S(Y°) to S(Y#) and money demand from RD(Y°) to RD(Y#). Under the assumption that savings supply and money demand grow by the same

margin the interest rate i# stays constant.


I(i)+RD(Y°)

Y° Y#

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-5

0

5

10

15

20

25

30

35

0 5 10 15 20 25 30 35 40 45 50


-0,5

0

0,5

1

1,5

2

2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

Y

C(Y)

YI#

Y#

I,SI(i)

I(i)+RD(Y#)i#

I#

C(Y)+I#

S(Y#)+M/P#

I#+RD#

i°

Y°

Consequently, the decrease in prices by firms causes a decrease in the interest rate, which causes an increase in investment. This increase in investment causes an increase in the demand for goods, which leads

ultimately to an increase in the demand for labor.


(->Exercise 27)

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4.1. The Keynesian Theory4.1.1. The "Keynesian Cross"4.1.2. The Keynesian Model with Capital Market

4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume 4.2.2. Reduction of the Propensity to Invest

4.2.3. Consequences for the Labor Market4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy

4.3.2. Monetary Policy4.4. The Long-run Implications of the Keynesian Model

4.5. Policy Conclusions 4.5.1. Practical Problems of Anti-cyclical Policy

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➤ As the above analysis has shown, “in the long run” (=when prices start to adjust) the economy is able to find its way out of recession without any help by the government.

➤ In other words, in the long run the “self-healing capacities” of the market work – even under the assumptions of the Keynesian model.

➤ This however means, that the Keynesian theory does not imply the necessity of government anti-cyclical policy.

➤ The Keynesian theory implies however that government business cycle policy makes sense, if it allows to accelerate the process of economic recovery.

➤ Such an acceleration of economic recovery is, however, only possible if the government (or the central bank) is able to react in face of a recession before firms start lowering their prices (and cause a recovery in this way).

4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications4.5.1. Practical Problems of Anti-cyclical Policy4.5.1. Practical Problems of Anti-cyclical Policy

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➤ Consequently, the time-frame for government business cycle policy corresponds to the span of time until firms start adjusting their prices (about 1 year).

➤ Only if the government (and/or the central bank) is able to increase the demand for goods before firms start adjusting their prices, it is possible to shorten the duration of the autonomous adjustment process of the economy.

➤ If fiscal and monetary policy come to late, i.e. when firms have already reduced their prices, this may cause an excess demand for goods that can lead to an overheating of the economy:

➤ The following graphs illustrate this problem:


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Ideal Case: No Implementation Lag => No Danger of Overheating:

Fiscal Policy becomes

effective: G↑

No reason for price adjustment, since the recession is

already overcome!

1 Year 1,5 Year0,5 YearStart of

Re-cession:

YD↓

Implementation Lag of Fiscal Policy = 0 Year

Start of Price Adjustment by Firms = 1 Year

=>

Increase in Demand

for Goods: YD↑

No Overheating,

since no price

adjustment takes place!

=>

Overcoming of Recession before 1 year

is over!

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Fiscal Policy becomes

effective: G↑

Firms decrease

Prices: P↓ => i↓=>I(i)↑

1 Year 1,5 Year0,5 YearStart of Re-

cession: YD↓

Implementation Lag of Fiscal Policy = 1 Year

Start of Price Adjustment by Firms = 1 Year

=>

=>

Increase in Demand

for Goods: YD↑

Increase in Demand

for Goods: YD↑

Twofold Demand Effect :

YD↑+YD↑

=> Over-heating of the

Econo-my

Realistic Case: Implementation Lag => Danger of Overheating:

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➤ As a consequence, the resulting excess demand for goods causes in the long run (when firms start to adjust their prices) an increase in prices, which will finally cause a recession (exercise 27).■ In this case, fiscal or monetary policy would not dampen but

boost business cycle fluctuations.

➤ These dangers lead to the question, whether the government (or the central bank) is able to react fast enough to reduce the duration of the recovery process and avoid an overheating of the economy.

➤ This question will be discussed in the following.


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➤ Practical experience with anti-cyclical fiscal policy has shown that there are several reasons for lags in the implementation of such policies. These lags can be classified according to the following scheme:

Total Implementation Lag

Inside Lag Outside Lag


Time between a shock to the economy and the policy action

responding to that shock.

Time between the policy action and its

influence on the economy.

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➤ The inside lag of fiscal policy has two sources:1. The government needs time to analyze the causes of a recession (“diagnosis lag”): Only in case of a reduction of the demand for goods caused by a deterioration of the expec-tations of firms and households (= demand side shock) Keynesian government spending policies will work. If the recession is caused e.g. by a shock in the prices of raw materials (= supply side shock), Keynesian spending policies will not work.2. The government needs time to change its budgeting:

■ On the expenditure side laws must be changed in order to increase government spending for goods and services.

■ On the revenue side laws must be changed in order to finance the additional government spending: Taxes and/or borrowing must be increased.

Changing laws takes time (weeks if not months) in a parliamentary system (“reaction lag”)


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➤ The outside lag of fiscal policy:■ Once the fiscal policy measures of the government are

implemented, some time is needed until they unfold their full influence on the economy:◆ In our textbook version of the Keynesian model a primary

increase in the demand for goods immediately causes an increase in income and the increase in income causes immediately an additional increase in household consumption demand via the multiplier effect.

◆ In reality, a couple of time is needed until households realize the increase in their income (and/or lower risk of getting unemployed) and react on this with a rise of their demand for goods.

◆ Therefore, in reality the multiplier effect needs much more time to get started than in the simple Keynesian textbook model.


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➤ Taken together, the implementation lags of fiscal policy may delay its effect on the real economy for a span of time, which is likely between half a year and one year. Hence the implementation lag comes close to the one-year lag with which firms adjust their prices!

Total Implementation Lag

Inside Lag Outside Lag


Time between a shock to the economy and the policy action

responding to that shock.

Time between the policy action and its

influence on the economy.

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➤ The Forecast Problem:■ In principle, business cycle forecasts could be one way to

circumvent the problem of implementation lags. ■ Such forecasts could help to start the implementation of

fiscal policy measures in advance, so that the effects of fiscal policy already start working at the beginning of a recession.

■ However this approach works only, if the forecasts are sufficiently reliable.

■ Experience has however shown, that forecasts of economicforecasts of economic developments are exposed to a high degree of uncertainty.

■ Forecasts of economic phenomena are forecasts of a complex system and are such as difficult as forecast of meteorological or ecological phenomena.

■ The following graph gives an example how difficult economic forecasting can be.


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Red Line: Actual US-unemployment rate.

Blue lines: Forecasts of the US-unemployment rate (average value of 20 US

forecast institutes)

Quelle: Mankiw, Gregory; Macroeconomics, Worth Publishers, S. 384Mankiw, Gregory; Macroeconomics, Worth Publishers, S. 384

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➤ The Policy Problem:■ Critics of the concept of anti-cyclical fiscal policy argue that

governments are not altruistic and benevolent agents committed to the public welfare only, but strive – like households or firms – to maximize their individual welfare.

■ If this hypothesis were right, it would be unlikely that governments would actually try to reduce business cycle fluctuations.

■ Instead they would use their economic policy instruments to increase the probability of being reelected.


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■ Therefore, these critics of fiscal policy argue that if governments were given access to a lot of fiscal policy instruments, they would not stabilize the economy but destabilize it with a “political business cycle” of the following kind:◆ A couple of time before an election, the government increases

government consumption, in order to rise the growth of income and reduce unemployment.

◆ This resulting improvement of economic conditions induces the electors to vote for the government.

◆ Once the government has won the elections, it will immediately reduce government consumption, in order the keep the government deficit in check – and be able to rise again government consumption before the next elections.

◆ This reduction of government consumption will cause a recession after the election.


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➤ To sum up:

➤ The practical implementation of fiscal policy is subject to a couple of problems that do not appear in the Keynesian textbook model:

1. The implementation lag

2. The Forecast Problem

3. The Policy Problem


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➤ Anti-cyclical monetary policy too can be subject to implementation lags:

■ The inside lag of economic policy is, however, typically much shorter than the inside lag of fiscal policy, since the central bank can change its money supply immediately without changes of laws that must be approved by the parliament (see chapter 6 “Monetary Theory and Policy”).

■ Nevertheless the outside lag of monetary policy can be quite important:◆Even though the effect of a change of monetary policy on

interest rates is quite direct and fast in reality (see the next diagram), a decrease in interest rates does not immediately cause an increase in firms’ demand for investment goods.

◆This is the case, because investment plans of firms are made in advance and it takes up to six months until firms actually demand more investment goods and hence increase economic demand.


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➤ The forecast problem is of course the same for monetary and fiscal policy.

➤ However, for an independent central bank, the policy problem of monetary policy is of less importance as for fiscal policy.

➤ Since the inside implementation lag and policy problem is of less importance, monetary anti-cyclical policy has much more proponents than fiscal policy.


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4. The Keynesian Model and its Policy Implications4.1. The Keynesian Theory

4.1.1. The "Keynesian Cross"4.1.2. The Keynesian Model with Capital Market

4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume 4.2.2. Reduction of the Propensity to Inves

4.2.3. Consequences for the Labor Markett4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy


4.5. Policy Conclusions 4.5.1. Practical Problems of Anti-cyclical Policy 4.5.2. Case Study: Fiscal Policy in Germany

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➤ The concept of anti-cyclical fiscal policy implies:

■ Increase of credit financed government consumption in recessions and, consequently, government budget deficits in recessions: T-G < 0

■ Dampening of economic activity in booms by a reduction of government demand and, consequently, government budget surpluses in booms : T-G > 0

➤ If periods of budget deficits and budget surpluses set off each other, the total amount of accumulated government debt should stay constant.

➤ This idea is displayed by the following graph:

4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications 4.5.2. Case Study: Fiscal Policy in Germany

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- 202 -figProf. Dr. Rainer Maurer

GD

P-L

evel

Time

0

UPSWING DOWN-SWING

UPSWINGGDP with perfect anti-cyclical fiscal

policy

Actual GDP without

anti-cyclical fiscal policy

Bu

dge

t Su

rplu

sThe Theory of Anti-Cyclical Fiscal Policy

+

−Budget Deficit = T-G < 0

Budget Surplus = T-G > 0

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- 205 -

800

1000

1200

1400

1600

1800

2000

2200

2400

-180,0

-160,0

-140,0

-120,0

-100,0

-80,0

-60,0

-40,0

-20,0

0,0

20,0

40,0

197019711972197319741975197619771978197919801981198219831984198519861987198819891990199119921993199419951996199719981999200020012002200320042005200620072008200920102011

Realer Haushaltsüberschuss insgesamt

Gleitender 7-jahres Durchschnitt des BIPs (rechte Skala)

BIP (rechte Skala)

Bn. €

Budget Surplus of Total Government and Business Cycles in Germany(Prices = 2000)

Bn. €

Real Budget Surplus

7-years Moving Average of GDP (right scale)

GDP (right scale)

UPSWI NG

DOWNSWI NG

UPSWI NG

UPSWI NG

UPSWI NG

DOWNSWI NG

DOWNSWI NG

DOWNSWI NG

DOWNSWI NG

UPSWI NG

UPSWI NG

DOWNSWI NG

DOWNSWI NG

UPSWI NG

- 205 -Prof. Dr. Rainer MaurerSource: SVR (2004)

UMTS-Auction

Acceptance of the Treuhand-Debt by the Government

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➤ As these charts show, there is no strong evidence that German governments since 1970 have followed the theory of anti-cyclical fiscal policy.

➤ If we add up the yearly budget deficits of the last chart (= DG,t) over the past, we receive the level of accumulated government debt:

LADG,t = DG,t + DG,t-1 + DG,t-2 + DG,t-3 +…➤ If we divide the level of accumulated government debt up to a

certain year t by the GDP level of this year, we receive the debt-GDP ratio:

LADG,t / GDPt

➤ If the growth rate of accumulated government debt is stronger than the growth rate of GDP, the debt-GDP ratio is growing.

➤ After the acceptance of the Treuhand-Debt by the government in 1996 the debt-GDP ratio reached for the first time the 60% limit according to the definition of the Maastricht Treaty.

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- 207 -

0%

10%

20%

30%

40%

50%

60%

70%

80%

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

Schuldenstandsquote (Gesamtverschuldung des Staates in % des BIP)

% of GDP

Will

i Bra

ndt

Hel

mut

Sch

mid

t

Hel

mut

Koh

l

Ger

hard

Sch

röde

r

Development of the Debt-GDP Ratio and the Change of Governments

Geo

rg K

iesi

nger

Ludw

ig E

rhar

d

Konr

ad A

dena

uer

Debt-GDP Ratio

Ange

la M

erke

l

- 207 -Prof. Dr. Rainer MaurerSource: SVR (2004)

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➤ To fight the steadily increase of public debt, the German parliament has implemented a so called “debt brake” in the German constitution (Article 115) by May 2009.

➤ According to this debt brake,■ the federal government must run a balanced government budget, i.e.

G = T, starting with the year 2016.■ the federal states must run a balanced government budget starting

with the year 2020.

➤ There are however exceptions:■ In a recession, debt financed government expenditure is allowed, if the

debts are reduced again in an upswing = anticyclical fiscal policy is allowed.

■ In case of “natural disasters” or “extraordinary emergencies” debt financed government expenditures are allowed, if it is ensured that the resulting debt is paid back afterwards.

What will the long-run consequences of the „debt brake“ be?

Does this make sense?

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4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume 4.2.2. Reduction of the Propensity to Inves

4.2.3. Consequences for the Labor Markett4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy


4.5. Policy Conclusions 4.5.1. Practical Problems of Anti-cyclical Policy 4.5.2. Case Study: Fiscal Policy in Germany 4.5.3. Limits of Government Debt

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications4.5.3. Limits of Government Debt4.5.3. Limits of Government Debt

➤ Is there an economic limit for government debt?■ Arithmetically the upper limit is the present value of maximal tax

payments, which depend on the politically maximal possible tax rate and GDP (τmax * Yt):

■ If the present value of all future interest payments on government debt becomes larger than the present value of the maximal possible future tax payments, the government is not able to serve its debt and has to declare bankruptcy.

T

0t tt

tmaxtT

0t tt

tt

i1

YE

i1

LADiE

Present value of future tax payments

Present value of future interest

payments≤

This equation shows that the “debt-to-GDP ratio” LADt / Yt is a reasonable empirical measure for sustainability of government debt.

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications4.5.3. Limits of Government Debt4.5.3. Limits of Government Debt

➤ Is there an economic limit for government debt?

■ Of course, governments will try to reduce their debt repayments before this upper limit is reached – they will “restructure” their debt: “debt restructuring” = “partial bankruptcy”

■ Since this is a risk for the creditors of government debts, financial markets will typically react long before the upper limit is reached and demand a risk premium (= higher interest rate).

■ In reality, the reputation of governments seems to play an important role for the level of such risk premiums, as the following diagrams show:

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0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

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20%

30%

40%

50%

60%

70%

80%

90%

2000

Q1

2000

Q3

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2001

Q3

2002

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Q3

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Q1

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2004

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2004

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Q1

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Q3

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Q3

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Q3

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Q1

2009

Q3

2010

Q1

2010

Q3

2011

Q1

2011

Q3

2012

Q1

2012

Q3

2013

Q1

German Interest Rate (right scale) German Debt-to-GDP Ratio

Debt-to-GDP Ratio and 10 yr. Government Bond Interest RateGermany

Debt in % of GDP Interest Rate

Source: Eurostat

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0%

5%

10%

15%

20%

25%

30%

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

2000

Q1

2000

Q3

2001

Q1

2001

Q3

2002

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2002

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2003

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2003

Q3

2004

Q1

2004

Q3

2005

Q1

2005

Q3

2006

Q1

2006

Q3

2007

Q1

2007

Q3

2008

Q1

2008

Q3

2009

Q1

2009

Q3

2010

Q1

2010

Q3

2011

Q1

2011

Q3

2012

Q1

2012

Q3

2013

Q1

Greek Interest Rate Spread vs. Germany (right scale) German Interest Rate (right scale)

Greek Debt-to-GDP Ratio German Debt-to-GDP Ratio

Debt-to-GDP Ratio and 10 yr. Government Bond Interest RateGreece vs. Germany


Source: Eurostat

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0,0%

1,0%

2,0%

3,0%

4,0%

5,0%

6,0%

7,0%

8,0%

9,0%

10,0%

0%

50%

100%

150%

200%

250%

2000

Q1

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2007

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2008

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Q1

2009

Q3

2010

Q1

2010

Q3

2011

Q1

2011

Q3

2012

Q1

2012

Q3

2013

Q1

Japanese Interest Rate (right scale) Japanese Debt-to-GDP Ratio

Debt-to-GDP Ratio and 10 yr. Government Bond Interest RateJapan


Source: Eurostat

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications 4.5.3. Limits of Government Debt4.5.3. Limits of Government Debt

➤ Why does the Japanese debt-to-GDP ratio not lead to higher risk premiums?

■ The creditors of Japanese government debt expect that the japanese government is able and willing to serve its debt in the future.

■ The expectations of financial markets play a crucial role in respect to the upper limit of government debt.

■ It is even possible that the phenomenon of self-fulfilling expectations appears, as the following scheme displays:

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- 218 -Prof. Dr. Rainer Maure

➤ Self-fulfilling expectations Self-fulfilling expectations of government bankruptcy:of government bankruptcy:

Doubts come up concerning the

ability of a government to repay all debt.

Sales lead to fall in market prices of government

bonds

Fall in market price = Increase of effective

interest rate

Ability of government to

repay debt falls.

Higher interest rates increase costs of

revolving government debt.


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- 221 -

0%

50%

100%

150%

200%

250%

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Public Net Debt-total in Percent of GDP (left scale)

Total Public Debt in Percent of GDPUnited Kingdom 1900 - 2010

Percent of GDP

Source: www.ukpublicspending.co.uk - 221 -

It is possible to reduce the debt-to-GDP ratio without reducing the

debt level…


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0%

50%

100%

150%

200%

250%

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

GDP Growth Rate (right scale)Public Net Debt-total Growth Rate (right scale)Public Net Debt-total in Percent of GDP (left scale)

Total Public Debt in Percent of GDPUnited Kingdom 1900 - 2010Percent of GDP Yearly Growth Rate

Source: www.ukpublicspending.co.uk

Nominal GDP must grow faster as the debt level!

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➤ Is there a “moral” limit for government debt?

1. Not future generations, but future tax payers pay for today debt:◆ Interest for government debt accumulated by current generations,

will not be paid by future generations, but by future tax payers to future owners of government bonds.

◆ Therefore, the money stays „within the generation“.

2. Every generation does not only inherit debt,◆ …but also net wealth like infrastructure, physical capital (machines,

buildings…), technical knowledge, institutions, human capital…

◆ The yearly monetary and non-monetary return, of this net wealth, is opposed to the interest payments, which have to be paid to the owners of government bonds.

◆ Is this return equal to the costs of interest payments, future tax payers suffer no net loss!

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4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume 4.2.2. Reduction of the Propensity to Invest

4.2.3. Consequences for the Labor Market4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy


4.5. Policy Conclusions 4.5.1. Practical Problems of Anti-cyclical Policy 4.5.2. Case Study: Fiscal Policy in Germany

4.5.3. Limits of Government Debt 4.5.4. Case Study: Economic Policy in the Great Recession

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4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession

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2009

Q01

2009

Q03

-2,0%

-1,5%

-1,0%

-0,5%

0,0%

0,5%

1,0%

Actual GDP growth minus trend growth (right scale) Actual GDP Trend GDP

Business Cycle Germany(Real GDP based on Chained Volumes, Reference Year = 2000, Trend = Hodrick-Prescott-Filter)

Source: Eurostat, Own Calculations

Bn. €

www.rainer-maurer.com

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0%

2%

4%

6%

8%

10%

12%

1990

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1990

Q03

1991

Q01

1991

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1992

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1992

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1993

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1993

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1994

Q01

1994

Q03

1995

Q01

1995

Q03

1996

Q01

1996

Q03

1997

Q01

1997

Q03

1998

Q01

1998

Q03

1999

Q01

1999

Q03

2000

Q01

2000

Q03

2001

Q01

2001

Q03

2002

Q01

2002

Q03

2003

Q01

2003

Q03

2004

Q01

2004

Q03

2005

Q01

2005

Q03

2006

Q01

2006

Q03

2007

Q01

2007

Q03

2008

Q01

2008

Q03

2009

Q01

2009

Q03

-2,0%

-1,5%

-1,0%

-0,5%

0,0%

0,5%

1,0%

Actual GDP growth minus trend growth (right scale)Unemployment Rate (left scale)

Unemployment and Business Cycle Germany(Real GDP based on Chained Volumes, Reference Year = 2000, Trend = Hodrick-Prescott-Filter)

Source: Eurostat, Own Calculations www.rainer-maurer.com

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Private Consumption in Current Prices, Billion Euro

Quelle: Statistisches Bundesamt


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➤ The expenditure account of GDP show the components of the demand for domestic goods:

Y = C + I + G + EX – IM

<=> BIP = Consumption

+ Gross Investment

+ Government Consumption

+ Exports

- Imports“Net Exports”


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Production in Manufacturing, 2005 = 100


As postulated by the Keynesian model firms adjust their

production in the short-run to the demand for goods.


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➤ As the data reveal, the current recession was mainly caused by a reduction of investment and export demand.

➤ The reason for the reduction of investment and export demand was the bursting of a speculative bubble on the US real estate market.

➤ The causal chain behind the development is relatively complex, as the following chart shows:


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USA GermanyDecrease in Real

Estate Prices

Net Wealth Loss of Households

Reduction in Con-sumption Demand

Reduction in Investment Demand

Reduction in Demand for Consumption and Investment

Goods from Germany

Reduction in Credit Supply by US Banks

Loss of Credit Receivables of

Ger. Banks

Loss of Credit Receivables of

US Banks

German Consumption

Relatively Stable

Reduction in Credit Supply by Ger. Banks

Reduction in Investment Demand

Reduction of Export Demand

Reduc-tion of

Produc-tion in Ger-many


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➤ Fiscal Policy Measures in Germany:➤ “Konjunkturpaket I” of November 2008 with a total volume

of about 100 Bn. €:

◆ Subsidization of building investment: energy saving investments

◆ Subsidization of investment in equipment: extension of write-off possibilities

◆ Extension of child allowances and other family support benefits

◆ Increase of credit supply for midsize companies: Sonderprogramm KfW – Bank


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➤ Fiscal Policy Measures in Germany:➤ “Konjunkturpaket II” of January 2009 with a total volume of

about 50 Bn. €:

◆ Reduction of income tax

◆ Reduction of health insurance allowances

◆ Additional Extension of child allowances

◆ Subsidization of private demand for cars (“Cash for clunkers”)

◆ Municipal investment program: Improvement of infrastructure


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➤ Geldpolitische Maßnahmen:

4. The Keynesian Model and its Policy Implications4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession 4.5.4. Case Study: Economic Policy in the Great Recession

0%

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9%

Jan 99 Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10

Main Refinancing Rate

Consumer Credits1)

Mortgage Loans1)

Corporate Credits2)

The Impact of the ECB on Credit Interest Rates of Commercial Banks

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4.6. Questions for Review

➤ You should be able to answer the following questions at the end of this chapter. All of the questions can be answered with the help of the lecture notes. If you have difficulties in answering a question, discuss this question with me at the end of the lecture, attend my colloquium or send me an E-Mail.

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1. What empirical developments in the course of the world economic crisis contradict neoclassical theory?

2. What are the two main differences between Keynesian and neoclassical theory.

3. What is the difference between the Keynesian and neoclassical consumption function and what implications does this have for the savings decision of households.

4. What is the economic explanation for the observed lagged price adjustment of firms?

5. Why do firms adjust their supply of goods to the household demand for goods in the Keynesian model?

6. What value has the Keynesian investment multiplier for a consumption ratio of 80%?

7. What is the increase in GDP under the assumption of the “Keynesian Cross”, if the consumption ratio is 75% and investment grows by 1 Bn. ?

8. Give a verbal explanation of the multiplier process.

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C, I, G

Y

9. Plot the following consumption function in this diagram: C(Y) = 0,8 * Y. How does this function change, if the consumption ratio decreases to 40%?

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- 246 -- 246 -Prof. Dr. Rainer Maurer-5

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0 5 10 15 20 25 30 35 40 45 50


C, I, G

Y

10. Determine (given the assumptions of the Keynesian Cross) GDP, if investment demand equals 5, government consumption equals 5 and the consumption function equals C(Y) = (1/3)*Y. How does GDP change, if government consumption grows by 10?

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11. Why does an increase in the demand for investment goods leads to an increase in GDP that is larger than the increase in the demand for investment goods under the assumption of the “Keynesian Cross”?

12. What possibilities does a government have under the assumptions of the “Keynesian Cross” to increase GDP?

13. Discuss the difference between the neoclassical and the Keynesian consumption function on the background of your own consumption behavior: Do you have a Keynesian or a neoclassical consumption function?

14. How does the “Keynesian Cross” have to be modified, if the capital market is taken into account?

15. What factors affect money demand of households and firms under the assumptions of the Keynesian model and what is their economic explanation?

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35

0 5 10 15 20 25 30 35 40 45 50


-0,5

0

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1

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2

2,5

3

3,5

0 5 10 15 20 25 30 35 40 45 50

Investment

Interest Rate

i1

C(Y)= (2/3)* Y

C(Y) + I(i)

I(i, E(r1))

Y1

S(Y1) = (1/3) * 30

I1

16. Caused by a deterioration of expectations, households lower their consumption ratio from 2/3 to 1/3 of their income. How does this reduction affect GDP in the above diagram?


Demand

Income

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-0,5

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2

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3

3,5

0 5 10 15 20 25 30 35 40 45 50

Investment

Interest Rate

i1

C(Y)= (1/3)* Y

C(Y) + I(i)

I(i, E(r1))

Y1

S(Y1)= (2/3) * 15

I1

17. Caused by a better economic outlook, households increase their consumption ratio from 1/3 to 1/2 of their income. How does this increase affect GDP in the above diagram?


Demand

Income

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0 5 10 15 20 25 30 35 40 45 50

Demand

Investment

Interest Rate

i1

C(Y)= (2/3)* Y

C(Y) + I(i)

I(i, E(r1))

Y1I1

18. Firms expect a decrease in investment returns and do therefore reduce their demand for investment goods by 5 units. How does this reduction affect GDP in the above diagram?


Income

S(Y1)

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Investment

Interest Rate

i1

I(i, E(r1))

S(Y1)

I1

19. Caused by a better economic outlook, firms expect a higher return on investment and increase their demand for investment goods by 10 units. How does this behaviour affect GDP in the above diagram?


C(Y)= (1/3)* Y

C(Y) + I(i)

Y1 Income

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Demand

Investment

Interest Rate

i1

C(Y)= 0,5* Y

C(Y) + I(i)

Income

I(i, E(r1))

Y1I1Y#

20. The above economy is in a recession with Keynesian unemploy-ment. To reestablish full employment, GDP must reach a level of Y# = 30 . Present government consumption is G = 0. What increase in government consumption is necessary to reestablish full employment, if government consumption is completely financed with credits?


S(Y1)

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Demand

Investment

Interest Rate

i1C(Y)= 0,5* Y

C(Y) + I(i)

Income

I(i)

Y1I1Y#

21. The above economy is in a recession with Keynesian unemployment. To reestablish full employment, GDP must reach a level of Y# = 20 . What increase in money supply MS/P is necessary to reestablish full employment? (Assume that the effect of an increase in savings is always absorbed by a corresponding increase in money demand).

I(i)+ RD(Y)

S(Y1) + M/P


S(Y1)

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22. Explain how a recession can be overcome with the help of fiscal and monetary policy under the assumptions of the Keynesian model.

23. Explain the practical problems of fiscal and monetary policy in realtiy.

24. Explain the mechanism that help to overcome a recession under the assumptions of the Keynesian model of the long run.

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0 5 10 15 20 25 30 35 40 45 50

Demand

Investment

Interest Rate

i1C(Y)= 0,5* Y

C(Y) + I(i1)

Income

I(i, E(r1))

Y1

S(Y1)

I1

25. How does an increase in money supply from M1/P by 5 units to M2/P = M1/P+5 affect the economy?

I(i, E(r1))+ RD(Y1)

S(Y1) + M1/P

I1

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Demand

Investment

Interest Rate

i1

C(Y)= 0,5* Y

C(Y) + I(i)

Income

I(i, E(r1))

Y1I1

26. How does an increase in government consumption from G1=0 to G2=10 affect the economy, if this increase is financed by credits.

S(Y1)


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27. This economy is in a boom, where the current GDP Y1 lies above full employment GDP Y#. Analyze what happens in the long-run, if firms begin to adjust their prices.


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Demand

Investment

Real Interest

i1C(Y)= 0,5* Y

C(Y) + I(i1)

Income

I(i, E(r1))

Y1

S(Y1)

I1

I(i, E(r1))+ RD(Y1)

S(Y1) + M1/P1

Y#

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-0,5

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0 5 10 15 20 25 30 35 40 45 50

Investment

Interest Rate

i1

I(i, E(r1))

S(Y1)

I1

28. The above economy is in a recession with Keynesian unemploy-ment. To reestablish full employment, GDP must reach a level of Y# = 20 . Present government consumption is G = 0. What increase in government consumption is necessary to reestablish full employment, if government consumption is completely financed with taxes levied upon household income?


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C(Y)= (1/3)* Y

C(Y) + I(i)

IncomeY#

Demand

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